A little over a year ago, I published an article in which I argued that holding mid to long term bonds were a bad idea. In the article, I also criticized the Canadian Couch Potato for incorporating an ETF that holds such bonds in their portfolio.

In this article, I will give an update on what has happened to the bond market since then, as well as what I see happening going forward.

XBB Performance

For those of you who don't know, the Canadian Couch Potato is a popular blog dedicated to index investing. While they generally have good content, I criticized their choice to continue to incorporate the iShares Canadian Universe Bond Index ETF (Ticker: XBB.TO) in their portfolios.

When you buy shares of XBB.TO, you essentially buy a basket of diversified bonds. These bonds have differing maturities, ranging from 1 to 25+ years. In my article, I argued against investing in mid to long term bonds, which make up the majority of XBB.TO, because I believed an increase in interest rates which would penalize holders of XBB.TO, was likely, due to the state of the economy at the time. If you want to learn about bonds and ETFs, check out our free book on investments.

On June 1, 2013 when I published the article, XBB.TO was priced at $31.05/share. In the first few months that followed, bond prices seemed to crater. By September 6, 2013, the price went down to $29.65, which represented a loss of 3.7% even after interest payments were taken into account.

However, since then, the price of XBB.TO recovered and closed at $30.95/share as of July 30, 2014. This meant that holders of XBB.TO gained 3.5% between June 1, 2013 and July 30 of the following year.

What Determines Longer Term Interest Rates

Looking at this gain, you might be tempted to say I was wrong, but before you do, consider the following.

Unlike many other investors, I never said that interest rates would definitely rise (which would cause XBB.TO to fall). However, I did say that interest rates were more likely to rise than to stand still or fall, since I thought it likely that the Canadian economy would recover.

I explained in my previous article that there was a link between the economy and interest rates, but I didn't fully explain just why that is the case. Let me explain this link in fuller detail.

In Canada, the central bank that controls interest rates is the Bank of Canada (BoC for short). However, the BoC doesn't control all interest rates. Rather, they only control the short term interest rates of Government of Canada bonds. Currently, the BoC has set the short term rate at 1%/year.

With respect to all other interest rates, including longer term government bond interest rates, the BoC lets the markets arrive at the 'right' or equilibrium rate. The interest rates of these medium to long term bonds reflect the market's expectation of short term rates in the future. In other words, if the market expects short term rates to remain stable, that expectation will steady medium and long term rates. If the market expects short term rates to rise, that expectation will increase medium and long term rates.

To understand why, let's take an example. Suppose an investor thinks interest rates on one year bonds will be 1% this year, and 2% next year. In this case, the investor will be indifferent between buying a two year bond that yields 1.5% per year, or buying one year bonds this year and next year, as both scenarios will generate the same returns for the investor.

However, if a two year bond yield 2% per year, then the investor will buy the two year bond, since that would generate higher returns for the investor. If many such investors buy two year bonds, the demand for two year bonds will increase, which will push the yields down until two year bonds yield 1.5% per year. The opposite would happen if two year bond yields are lower than 1.5%. The lack of buyers and more sellers would push the yield up to 1.5% per year.

In this example, two year bonds will have to yield 1.5% per year because investors expect one year bonds to yield 2% next year. If they expected the one year bond to yield 3% next year instead, then two year bond yields would have to arrive at 2% (i.e. average of 1% and 3%).

In other words, longer term bond yields depend on investors' expectations for future short term bond yields. Since the BoC controls the short term yields, the longer term yields indicate what investors think the BoC will do in the future.

What Determines Short Term Interest Rates

To understand movement in medium to long term interest rates, we therefore need to understand what makes the BoC move short term rates.

Officially, the BoC is mandated to keep inflation within a specific range, between 1 and 3%. If inflation goes above this range, the BoC will typically raise rates, and vice versa.

Higher interest rates make it unattractive for people to borrow money, so they take out fewer mortgages, buy fewer cars on credit, and basically spend less. This forces the economy to cool down, and brings inflation down as well. On the other hand, lowers interest rates encourage people to borrow money, which stimulates the economy and brings up inflation.

Therefore, if the economy does well, investors anticipate that the BoC will raise rates. This makes medium to long term interest rates go up. The opposite happens if the economy doesn't do so well, and this expectation causes medium to long term rates to fall.

In the latter half of 2013, the Canadian economy appeared to be doing well. The unemployment rate fell from over 7.2% in May 2013, to 6.9% in Oct 2014. This led investors to believe that the BoC would increase rates soon, which raised medium to long term interest rates (i.e. lowered bond prices).

However, in January 2014, the unemployment rate unexpectedly shot back up to 7.2%. This sudden surge in unemployment jolted interest rates back down. If you look at historical XBB.TO prices, you can see the price surge in January.

In June 2013, the unemployment rate stood at 7.1%. As of June 2014, the unemployment rate remained the same. Other key economic indicators that the BoC pays attention to have similarly shown very little improvement over the last year.

This is a little surprising result, particularly as our neighbours south of the border have done much better. In June 2013, the U.S. had an unemployment rate of 7.6%, but by June 2014, the rate had gone down to 6.1%. As a result, their long term bond yields went from 2.15%/year on June 1, 2013 to 2.58%/year on July 30, 2014.

As a result, the U.S. bond ETF named iShares 7-10 Year Treasury Bond ETF (Ticker: IEF), which has a similar average duration to XBB.TO, recorded a gain of just 0.2% between June 1, 2013 and July 30, 2014. U.S. investors would have been better off buying short term bonds instead.

I had assumed that there was a high chance that the Canadian economy would follow a similar trajectory to the U.S. economy. Was I wrong to assume so? I'll let you decide.

What The Future Holds

So far, I've only talked about what happened in the past. But what can we expect in the future?

As before, the prices of Canadian bonds will continue to depend on economic factors like the unemployment rate. If the unemployment rate remains high, then we can expect to see bond prices stay where they are. If the unemployment rate goes up, we can even expect bond prices to increase further.

While I can easily think of such a scenario (a crash in housing prices will do that, for instance), I'm not sure if such a scenario is likely. If history is any guide, the Canadian economy should follow the U.S. economy up, even though that hasn't happened yet. In that scenario, I expect bond prices to go down again from here.

According to Warren Buffett, the number 1 rule of investing is "Never lose money". The number 2 rule of investing is "Never forget rule number 1". This is what I try to keep in mind as I construct MoneyGeek's portfolios. For that reason, I will continue to incorporate XSB.TO, the short term bond ETF, instead of the riskier XBB.TO.